Any value out there at the moment?
It seems to many that the year about to conclude has been a tough one for investors. On a macroeconomic level the US Federal Reserve’s warnings of rate rises, followed by inaction, made uncertainty a given, while China’s deepening slowdown combined with a local chase for yield, set many investors up for a painful reckoning.
But none of this should have been relevant to investors focused on quality businesses. Those investors would have held no Rio, no BHP, no Woolies and no NAB. The way to outperform the market this year has been to avoid those companies conventionally referred to as blue chips and instead buy what we refer to as the true blue chips.
Beating the market is possible, but what is required is a portfolio that looks very different to the market index.
The question you may then ask is what are the characteristics of a quality business and do any exist today that are both high quality and still representing reasonable value?
The key ingredient when determining quality is quite straightforward. You need to be invested in businesses that can retain large amounts of their profits or large amounts of equity capital, and they must be able to generate high returns on that equity capital without the need for significant debt. In short, it is far better to have a smaller business generating a high return on incremental equity than a large business that generates a low or mediocre return on equity.
Of course, it is important that these businesses can sustain those attractive rates. And that’s easier said than done. High rates of return are bound to attract competition and those competitors won’t rest in trying to take customers (market share) from the incumbent business. In order to stave off competitive threats, a company needs a sustainable competitive advantage. Usually that is something that isn’t easily replicable. It could be reputation, geographic location, popularity (network effect) or historical cost advantages. The most valuable competitive advantage is something that gives the business the ability to charge a higher price without any detrimental impact on unit sales volume.
With those elements in mind, the following companies are worth mentioning, IPH, Magellan, iSentia, CSL, Medibank, Sirtex, Ramsay Healthcare, REA Group, Carsales and Challenger. The list, of course, is not exhaustive but it is a good start for you to begin your research.
In addition to being high quality as described above, it is also essential that the prospects for the product or service are bright. Without bright prospects, you may identify a business that only looks wonderful in the rear view mirror.
Finally, it is essential that the company’s shares are trading at a treasonable price. We determine this by comparing the price to an estimate of what we believe the company is worth on a per share basis. So for every company we invest in, we estimate something called intrinsic value. You can read more about intrinsic value online or in my book Value.able.
The question that remains is; are there currently any companies that are both good quality and cheap?
Generally there are more opportunities than we have spotted recently. That in itself is telling – it means the market is generally expensive and at risk of weakness. Given that caveat, some of the following companies do appear to be below our estimate of their value; iSentia, REA Group, Henderson Group, Chorus and Medibank Private are some of the names that appear cheap.
Keep in mind, estimating a company’s intrinsic value is not the same as predicting its share price. Even though the share price might be below our estimate of its value, that does not mean the shares are immune from declines. We cannot predict what share prices will do and that’s why it’s useful to ask your adviser to only buy when the shares are at very large discounts to his or her estimate of their value. Oh, and don’t forget, valuations can change too. They change much more slowly than share prices but they do change. For the sort of business we want to invest in, intrinsic values should be rising over time.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
tim clare
:
Hi Roger,
Given that ISD at $4.80 was below your estimated IV in December 2015, is it now a screaming bargain (having fallen over 30%)? or have the fundamentals changed to downgrade value?
Kind regards,
Tim.
Roger Montgomery
:
Hi Tim,
We still hold the stock. Buffett once said ‘don’t take your cues from price’. And Ben Graham said ‘don’t listen to Mr Market, its his wallet you want to take advantage of, not his wisdom.’ Before you go racing in, be sure to comprehensively research the company yourself and then seek and take personal professional advice.
Slammer
:
Hi RM,
If i’m going to jump on a copy of Value.Able – can I get it signed? Would be great!
Cheers!
Roger Montgomery
:
Yes, Just ask Jodene or Gracie at the office.
Guy Davis
:
Hi Roger, another interesting article. I have just re-read Value.able because I am working on nailing down IV calculations and I had a question about the method you describe in your book. When you use the Value.able method are you assuming that the company you are valuing will maintain the chosen ROE into infinity?
I am finding that the method is giving me much lower values than a traditional DCF to equity calculation, which obviously includes a terminal value to cap the growth rate after the expansion period.
Although this too is puzzling, because I would’ve thought a method that doesn’t include a terminal value would give higher values than one that does.
DCFs aren’t throwing up too many opportunities either as you mention in your article, but my Value.able numbers seem far too low.
I know IV formulas depend on the inputs by the operator, but I am being as consistent as I can across the methods and would appreciate any tips on why the Value.able method might be showing the market drastically expensive atm, even for stocks that I know you consider cheap.
Regards,
Guy Davis
Roger Montgomery
:
Hi Guy, As I mention in the book it is a ‘straight-line’ model and therefore does require continuity. Obviously the present value of a number out at infinity is so small as to be inconsequential and so one doesn’t need to expect every company to grow infinitely. If your models aren’t throwing up opportunities it doesn’t mean the models are wrong. Remember that coming up with a valuation that approximates the current share price, is not the purpose of valuing a business.
Ben Wortley
:
Hi Roger,
You have previously discussed IMF as a quality business. What are your thoughts now? The market seems to have held a poor view of the company since it lost the case with the major banks.
By my calculations it is trading below intrinsic value.
Ben
Roger Montgomery
:
It does look as though the previous track record and win/loss ratio has not been a good guide to current performance.